No Free Lunch in Dividend Funds

There’s no such thing as a free lunch, but there is an inexhaustible supply of investors who will trip all over themselves in pursuit of it.

Consider portfolios of dividend-paying U.S. stocks, which sparkled in 2010 and 2011. Mutual funds of that type returned 18.1% cumulatively, while exchange-traded funds devoted to dividends earned an average of 28.7%. Over the same period, the S&P 500 returned 17.5%.

What happened next was the latest proof of some of the oldest lessons in investing: Even a good idea turns bad when too many people try it at once, and those with unrealistic expectations are the first to panic at the slightest disappointment.

Brokers pitched dividend funds as a way to get higher returns and lower risk than the stock market itself—and investors stampeded to join the party.

From 2010 through 2013, high-dividend mutual funds and ETFs took in more than $112 billion in new money, estimates Morningstar, the investment-research firm.

By the end of last year, these funds had amassed a total of $394 billion in assets. That was more than triple their size at the end of 2008. Over the same period, total assets at U.S. stock funds barely doubled.

But the party already was winding down. Last year, dividend-oriented funds underperformed the S&P 500 by an average of roughly four percentage points; so far in 2014, they are trailing by half a point, Morningstar reckons.

That was mainly because faster-growing stocks raced ahead on hopes of a continued economic recovery.

Right on cue, investors began to reverse course, yanking $2.5 billion out of dividend mutual funds in the first four months of this year.

“Maybe for some people, their expectations were to get the safety of the dividend and to participate fully if the market goes on a tear,” says Tom Huber, portfolio manager of the $4.1 billion T. Rowe Price Dividend Growth Fund, which has lagged behind the S&P 500 by 1.3 percentage points in 2014.

But dividend-paying stocks offer a trade-off, not a free lunch. “You should outperform in choppier, lower-return markets,” Mr. Huber adds, “but you’re not as likely to participate fully on the upside in strong markets.”

Dividend funds tend to be less diversified than the stock market as a whole, tilting heavily toward large companies and electric utilities, which typically offer higher, steadier payouts. Many such funds hold 10% to 30% of their assets in utilities, or three to 10 times that industry’s weight in the S&P 500.

So when the market heats up on the prospects of improving economic growth—as it did in 2013—dividend-paying stocks are left behind.

Last year, in fact, a near-opposite strategy did far better: A portfolio specializing in companies that use their excess cash primarily to buy back shares rather than to pay dividends—the AdvisorShares TrimTabs Float Shrink ETF—clobbered the average dividend ETF by more than 13 percentage points.

In the long run, dividend funds should provide at least an indirect way to focus on underpriced stocks.

Such funds capture some of the excess return offered by cheap “value” shares, which tend to pay out more of their earnings in dividends, says Luciano Siracusano, chief investment strategist at WisdomTree Investments, which manages approximately $30 billion in dividend-oriented ETFs.

He adds that they also may pick up what researchers call the “quality” effect, an extra fillip of return provided by companies whose businesses become more profitable over time—probably because such firms can afford to sustain their dividends.

As a result, dividend-paying stocks have historically outperformed the rest of the U.S. market by up to one percentage point annually over the long run, Mr. Siracusano estimates.

At some funds, taxes from short-term trading could gnaw away at that advantage. Not all the income paid out by dividend-oriented mutual funds is taxable at the lowest 23.8% rate. Of the 122 dividend-oriented funds identified by Morningstar, 64 paid out some short-term capital gains in 2013, taxable at up to 43.4%.

You can always generate your own income from a stock portfolio, a mutual fund or an ETF by periodically selling a small portion of your holdings—creating what many investors call “homemade dividends.”

The profits on partial sales of shares you have held longer than one year are taxed as long-term capital gains, at a maximum rate of 23.8%, and you retain complete control over how much income to take, and when.

Still, dividend funds aren’t a bad idea—unless you bought them for the wrong reasons. Says Mr. Huber of T. Rowe Price: “You have to be prepared to give up some of the upside for a strategy that hopefully helps you sleep a little better when things are tougher.”

If you were hoping instead for a free lunch of lower risk and higher return, you will end up going hungry.